Genworth: Why It Could Surge 80%

The housing crisis, stretching from 2007 to 2010, buried its U.S. mortgage-insurance business in an avalanche of foreclosures, falling home prices, and steep mortgage-claim losses. At the same time, the long-term care insurance (LTC) business went so sour that big competitors like
MetLife
(ticker: MET) chose to pull out completely while Genworth (GNW) persevered. Policies, many of them written decades earlier on customers in their 50s, unexpectedly went to claim for far longer periods than expected (in part due to a surge in Alzheimer's and dementia cases) producing a sea of red ink.

Barron's saw signs of recovery more than a year ago ("Why Genworth Will Finally Reward Investors," March 11, 2013), when the insurer was reorganized by CEO Thomas McInerney. As we projected, the shares popped from $9.65 to over $18. But added worries about its LTC business have caused the stock to give back nearly 30% from its May high of $18.74. Most of the damage occurred after the release of second-quarter results in July showing a drop in operating profit from its LTC book to $6 million from $46 million the quarter before. Worse, the company said the unexpected surge in claim losses had prompted it to review the adequacy of reserves on existing claims.

The company added that the results of the review and whether it will need to take any reserve charge will be disclosed by the end of the third quarter. The reserve news came just seven months after Genworth management had done a "deep dive" into its LTC reserves and given an "all clear" determination to analysts.

"The possibility of a reserve charge has hung over the stock in recent months even though it's unlikely to be that onerous," says Compass Point analyst Ken Billingsley, who has a one-year price target of $16.50. "Some question how management can suddenly freak out over just one quarter of claims experience, which can be quite volatile. In my view, the stock market reaction is quite overdone."

We share Billingsley's view. First, the tangible book value per share of Genworth's stock -- even with a draconian reserve charge of $1 billion -- would still total more than $29 a share from a current $31.37, or more than twice its recent stock price. Any charge is likely to be far smaller -- maybe in the $200 million range -- that can be easily covered by the company's excess regulatory net worth with room to spare.

Recent Price

$13.26

52 Week High-Low

$18.74-$11.91

Market Value (bil)

$6.6

EPS 2014E

$1.29

EPS 2015E

$1.57

P/E 2015E

8.5

E=Estimate Source: Bloomberg

We think Genworth has an excellent chance in the next few years of closing the gap between its stock price and book value by trading for at least book value, like
Prudential Financial
(PRU), MetLife, and
Torchmark
(TMK). In this case, book value excludes accumulated other comprehensive income, a balance-sheet item. On this basis, Genworth's book value is $24.31 a share, about 80% over its recent $13.26.

True, as Raymond James analyst Steven Schwartz notes, Genworth had an operating return on equity of just 5.2% in the second quarter while its life-insurance peers were posting 10% or higher. Yet Genworth's earnings -- even with the LTC miss in the second quarter -- are clearly in an uptrend. Consensus analyst estimates are for $1.29 a share this year and $1.57 and $1.75 in 2015 and 2016, respectively. This compares with operating earnings per share of $1.24 last year and 82 cents in 2012. Moreover, management, who declined to talk to Barron's until after the LTC review is done, is still guiding to an improvement in return on equity to 7% to 9% by 2016, according to a conference call this summer.

We would lean toward the high end. First, Genworth's primary business, mortgage insurance, has recovered nicely from the horrors of the housing crash with a lot of the resulting mortgage loss claims already flushed down the company's alimentary canal.

Its mortgage-insurance operation reported net operating income of $136 million in the second quarter, compared with $102 million a year earlier. Results were bolstered by a decline in claims losses as delinquencies trended lower and loan recoveries improved. Mortgage insurers face a brighter future, given the tighter underwriting standards and the various reform plans calling for a bigger role to be played by private risk capital.

GENWORTH HAS BEEN HARD AT WORK on the long-term care front, trying to reverse previous underwriting errors. Beginning in 2012, the company has won premium increases from 43 states with more on the way elsewhere, which will boost its annual premium income by $250 million to $300 million by 2017. Genworth has also tightened policy terms, all but dumping lifetime benefits two years ago in favor of maximum benefit periods limited to three to five years.

The Bottom Line

Meriting a price-to-book value closer to that of its rivals, Genworth shares could be worth more than $24 each in a few years, versus $13.26 last week.

The big problem for Genworth's LTC business remains its older block of policies covering some 331,000 lives. The policies, which were sold between 1974 and 2001, assumed a lapse rate of 5% to 5.5%, or the percentage that would be canceled over the policy's life. A higher lapse rate means Genworth would be able to pocket years of premiums and investment returns without having to pay a benefit. However, folks hung on to their policies: Lapse rates were 1% or less. Also, the company assumed premium investment returns on these policies as high as 6.75%, but yields are currently running at 5.5%.

Genworth hopes only to break even on the policies. A recent investor figures the block of 331,000 should shrink to 123,000 policyholders in the next decade based on mortality statistics.

Such is the calculus of the LTC business. A grim denouement for the policyholder is a boon for the investor.

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